Conducting Due Diligence of Sub-Advisors and Third-Party Advisors

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Growing up, investment advisors may have been warned by their parents to avoid hanging out with the wrong crowd. The same advice applies to RIAs recommending sub-advisors and third-party advisors.

At some advisory firms that utilize sub-advisors, due diligence is overdue or non-existent. “Due diligence” is the level of investigation expected of a prudent RIA to determine whether an investment or business arrangement makes sense. In view of the Bernard Madoff scandal and the current regulatory environment, the duty to conduct due diligence is more important than ever. RIAs should conduct an extremely thorough investigation before utilizing sub-advisors, and should disclose situations where they utilize sub-advisors and third-party advisors in their Form ADV Part 2 disclosure brochures.

It is important to recognize that there is no one-size-fits-all process for due diligence of unaffiliated advisors. It is also important to distinguish between sub-advisory and third-party advisory relationships, even though the terms are often used interchangeably. For our purposes, we view the sub-advisory relationship as an agreement between the sub-advisor and the RIA. In contrast, the third-party advisory relationship is between the third-party advisor and the client. The RIA usually recommends the third-party advisor and monitors that entity’s performance.

A rigorous due diligence process is necessary when utilizing sub-advisors and third-party advisors. In all circumstances, an RIA should take into account the nature of the relationship with the client and the services it has agreed to provide.

Avoiding Sub-Par Due Diligence of Sub-Advisors

The due diligence process goes far beyond investigating whether a sub-advisor is in good standing with securities regulators. Furthermore, RIAs should not rely on a sub-advisor’s marketing materials and reputation in lieu of conducting their own due diligence. According to Ric Edelman’s article in the February 1, 2009 online edition of InvestmentNews, Madoff’s website boasted, “clients know that Bernard Madoff has a personal interest in maintaining the unblemished record of value, fair dealing, and high ethical standards that has always been the firm’s hallmark.” Needless to say, Madoff’s record is now officially blemished.

While conducting due diligence, RIAs should sort through all available information to choose the right sub-advisor to handle their clients’ funds. As we will see below, RIAs should review the sub-advisor’s Form ADV, as well as its compliance policies and procedures. The sub-advisor’s investment strategy should be transparent and logical. Additionally, RIAs should evaluate the performance returns supplied by the sub-advisor.

An RIA should review documentation such as the sub-advisor’s:

code of ethics;

organizational charts and history of the firm;

policies and procedures including insider trading policy;

copies of correspondence with securities regulators and SROs; and

complaints and litigation.

Due diligence does not end after the RIA engages the sub-advisor. RIAs must continually evaluate the sub-advisor making certain it still meets or exceeds the high standard that led to its selection. As events and situations change, RIAs should evaluate all of the information at their disposal to determine if the sub-advisor selected continues to be the best choice for their clients.

Authority to Hire and Fire Sub-Advisors

Typically, RIAs select a sub-advisor to manage a client’s account or some portion thereof. Generally, the sub-advisor only communicates with the RIA and does not have direct contact with the RIA’s clients. Although the RIA may not have investment discretion or trading authority over the account, the firm retains the authority to hire and fire the sub-advisor. As a general rule, the RIA is also authorized to reallocate the client’s assets to other sub-advisors if this action is deemed to be in the best interest of the client.

Discretionary authority to hire and fire managers should be clearly described in the advisory agreement. Form ADV should also fully disclose that the RIA is authorized to hire and fire sub-advisors. With this authority comes an obligation on the part of the RIA to conduct due diligence of the sub-advisor at the inception and throughout the sub-advisory relationship.

Duty to Conduct Due Diligence of Sub-Advisors

Before entering into a relationship, RIAs should conduct a thorough review of the sub-advisor’s qualifications, expertise, and fees. These fees should be reasonable in view of the potential value brought to the client’s account.

RIAs should clearly understand a sub-advisor’s strategies for investing money. A sub-advisor’s approach to investing should be transparent and clearly defined. In contrast, Bernard Madoff was quite secretive about his investment strategy that purportedly relied upon a proprietary trading model that provided buy-and-sell signals. According to published reports, Madoff was able to conceal reportedly fraudulent activities, because he operated his business in secrecy. Some RIAs severed their relationship with Madoff before his Ponzi scheme became public knowledge, because they could not verify how he achieved consistently high returns year after year.

Due diligence is a far more arduous process than just investigating a sub-advisor’s performance track record. An RIA should examine the underlying factors, which led to those performance results, and determine whether they are likely to continue. The RIA should also be certain that the sub-advisor is not taking excessive risks to achieve those returns.

The sub-advisor’s portfolio management strategies should be suitable in view of each client’s time horizon, risk tolerance, and investment objectives. Throughout the relationship, RIAs should look out for signs of style drift—when sub-advisors drift away from the investment strategies that led to their being hired.

Before turning over funds, RIAs must review compliance controls in place for the sub-advisor, ensuring that the firm will meet the fiduciary duties owed to clients. For example, RIAs should make certain controls are in place governing the sub-advisor’s cash movement and accounting practices. Controls designed to ensure the accuracy of the sub-advisor’s pricing and valuations should be reviewed by RIAs, along with trading policies and procedures.

RIAs should review the sub-advisor’s Form ADV to learn more about actual and potential conflicts of interest. In addition, RIAs can examine a sub-advisor’s internal or external compliance audit reports for recent years. If these reports indicate that compliance policies and procedures are weak or deficiencies have not been corrected, the RIA should consider another sub-advisor. If there are unanswered questions, RIAs should meet with the sub-advisor’s compliance personnel, either in person or by phone.

The duty to conduct due diligence does not end after the contract is signed. An RIA has a continuing obligation to monitor the sub-advisor’s performance and business practices. The firm must investigate any complaints from clients about the sub-advisor, and RIAs should routinely review the sub-advisor’s compliance audit reports or conduct their own investigation.

Due Diligence of Custodians

Due diligence involves much more effort than just investigating the sub-advisor. RIAs should also investigate the sub-advisor’s custodial relationship, and should be certain that the sub-advisor uses an independent custodian who is financially secure, experienced, customer-oriented, and well regarded in the investment community. It is imperative that custodians possess adequate insurance, and utilize a suitable sweep money market fund that bolsters clients’ returns.

RIAs need to review the types of reports and statements generated by the sub-advisor’s custodian, which should be clear and easy to understand. The custodian should be able to produce timely and accurate performance reports, as well as tax statements.

Policies and Procedures as They Relate to Sub-advisors

An advisory firm’s policies and procedures articulate the manner in which the RIA conducts due diligence of sub-advisors. Due diligence should occur before hiring a sub-advisor and must continue on an ongoing basis. As part of this process, RIAs should consider taking the following steps:

Thoroughly review a sub-advisor’s current Form ADV brochure and brochure supplements

Require the sub-advisor to forward its Form ADV whenever it is amended

Interview key personnel at the sub-advisor and make onsite visits where it is appropriate to do so

Request the results of regulatory examinations and corrective actions to remedy deficiencies

Require notification of any relevant litigation, including client complaints

Require the sub-advisor to certify annually that the firm complies with all of its policies and procedures, as well as federal securities laws

Conduct periodic meetings with compliance personnel of the sub-advisor

Review client account statements and reports to ensure their accuracy

Monitor performance results in relation to established benchmarks

Mandate that the sub-advisor notify the RIA if there are changes in its portfolio management team or investment strategies

A higher level of due diligence may become necessary if a key member of the sub-advisor’s team leaves the firm. On an ongoing basis, RIAs must examine whether the reasons for choosing the sub-advisor still exist. Due diligence should be increased if there are material changes in market conditions, regulatory developments, or any other event likely to have a significant impact on the sub-advisor’s operations.

If an advisory firm does not use sub-advisors, its compliance manual should not contain any of these policies and procedures. Extraneous policies and procedures that do not apply to their business model should be eliminated.

The Big Picture

Engaging in due diligence of sub-advisors isn’t just a recommended best practice—it is part of fiduciary obligation to a client. An RIA should be extremely reluctant to enter a relationship with a sub-advisor who claims the firm’s strategy is proprietary. Without a general understanding of the strategy utilized, an RIA does not have enough information with which to evaluate the sub-advisor.

Just as portfolios must be well diversified, RIAs might use the same approach when choosing sub-advisors for their clients. It may make sense to diversify clients’ assets among several sub-advisors—not just one whose performance might not meet or exceed expectations. This gives RIAs the opportunity to compare sub-advisors over a period of time. A client might also need sub-advisors that specialize in particular asset classes, such as fixed-income investments.

Exercising the highest level of due diligence is meaningless unless RIAs document their process. It should be clear from the firm’s internal memorandum that the RIA used a thorough and well-researched process before selecting a sub-advisor. A document should be created that explains the data affecting this decision and why a particular sub-advisor was chosen or not. There should also be detailed records, as well as policies and procedures, demonstrating that the due diligence process is ongoing and did not come to a halt after the sub-advisor was selected. Moreover, if RIAs have not created and retained formal documentation to show that they are conducting due diligence of sub-advisors, it is long overdue.

Les Abromovitz

Les Abromovitz is the author of The Investment Advisor’s Compliance Guide, published for 2012 by The National Underwriter Company/Summit Business Media. Les Abromovitz is an attorney and member of the Pennsylvania bar. Les has handled hundreds of consulting and publishing project for a leading compliance and regulatory services firm. He has conducted a number of seminars and training sessions dealing with compliance subjects. Les is also the author of several White Papers that analyze compliance issues impacting Registered Investment Advisors (RIAs).

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